Real estate investments are made for two main reasons. One is to provide a stable source of current income, the other is to provide a hedge against inflation. Popular thinking is that the investor can gain both through the purchase of income producing property. And while this is true, this investment may not yield the highest return possible with the least risk.
As in any passive investment, the investor will pay a price, either direct or indirect, for the management of his investment. Sure the investor can act as his own property manager, accountant, broker, etc., but that part of investing is really being in business. As such an appropriate amount of compensation must be deducted from income for the performance of these business services if we are to arrive at an accurate reading of the investment’s return.
Currently, owners of income producing real estate are holding out for high prices (low return to buyers) in this market environment. The owners can hold out because (1) they are collecting positive cash flow on their investment and (2) their interest rates on loans they were able to obtain years ago are at historic lows. This combination makes for few distressed sales in the commercial market of income producing property. The property that can be obtained at large discounts are non cash flowing properties, which investors reject because these properties do not meet the first reason for investing, providing a stable current income. About the best the investor can do is obtain property yielding 7 -8 % annually with little upside potential.
I have been able to create a real estate portfolio yielding significantly greater current returns with significantly greater upside potential. I have accomplished this by separating my real estate investments into two groups, one for income and the other for capital growth/inflation protection.
For the current income portion I own high yield trust deeds. These are hard money loans made using real estate as collateral. Yields are 15-18%, with low loan to value ratios. I lend a maximum of 55% of value on income producing property, 30% on city lots and 15-20% on raw land. My foreclosure experience has been fairly low (12-15%), so my return over time has averaged about 16% annually.
The second part of my portfolio is non cash flowing real estate. The reason for this is that I am able to obtain this type of property at 60% of value. Many owners of non cash flowing properties are highly motivated to sell as they have no income from the property. Many have over extended in far too many properties, and selling for a low price is their only way out. Picking up properties with a built in equity is quite an advantage, when the real estate market recovers profits on these properties will be twice the profits on cash flowing properties purchased at market value.
I believe that the proper balance for this portfolio is 2/3 in high yield trust deeds, 1/3 in properties purchased at large discounts. This is not as one sided as it seems because there will be some defaults and hence opportunities to own a few of the properties lent on at a fraction of market value. Further, I am talking about purchasing the properties for cash, so what little immediate cash flow can be obtained from the property will be enough to pay taxes, insurance and any other holding costs. Even land can be leased in various ways, usually for enough to pay taxes (insurance in usually not a concern on unimproved property).
So let’s see how my portfolio performs. With 2/3 in trust deeds, my overall yield on the portfolio is about 11 – 12 % (16 -18% on 2/3 of the portfolio, 0 current income on the other 1/3). If inflation hits as I suspect it may, prices may double in five years. Since I am into these properties at 50% of value, a doubling will actually increase the value of the non income producing portfolio by a factor of 4X. If we have no inflation and my property values stay the same, I merely double my money. So I am being paid 11-12% current return on my real estate portfolio and have tremendous upside.